Three Reasons to stay Bullish on Stocks - and One Reason to Worry

I just finished my quarterly letter to my institutional clients which I have reprinted below.

I remain positive on the near-term outlook for stocks, since most of the reasons for the first quarter rally remain in place. On the other hand, the high degree of bullish sentiment and complacency gives me pause, and I think that this is not a "buy-and-hold" market.

Despite a blizzard of bad news, the stock market turned in its strongest quarterly performance in 13 years during the first three months of 2011.

The S&P 500 produced a total return of nearly +6% during the first quarter. The energy sector (+16% for the quarter) was the clear winner, followed by industrials (+8%). Laggards included utilities (+2%) and consumer staples (+2%).

Markets are being buoyed by several factors, but here are the most important in our opinion:

1. The Fed continues to be very accommodative. Since the announcement of QE2 in late August, the market has turned in very handsome returns – the S&P is up over +27% in the last 7 months. Interest rates (as measured by the U.S. Treasury 10-year note) are still lower than they were a year ago, helped by the Fed’s active program to support the bond market;

2. News from corporate America is generally positive. Many companies are reporting near-record profit margins despite tepid sales growth. Continued cost cutting measures - including layoffs – have helped, as has utilizing the internet to improve efficiency. Outsourcing manufacturing to lower wage countries has also helped;

3. While investors might be still scarred by the difficult bear market of 2008, the investment alternative to stocks are less attractive. Low interest rates have made holding cash unappealing. Shorter maturity bond yields also remain at record lows. In many cases, dividend yields are higher than corporate bond yields issued by the same company.

We remain positive on the stock market for the next few months at least. The Fed is unlikely to change its accommodative stance any time soon, especially since housing remains mired in a deep funk. Corporations are generally optimistic, and are looking to overseas markets as a possible source for new growth opportunities. Finally, valuations of stocks also are not out-of-line with historic averages.

That said, we are mindful that it is often during periods of widespread bullish sentiment that markets become most dangerous. Numerous recent surveys have indicated that both institutional and individual investors have turned very positive on the outlook for stocks, which is a marked contrast from a year ago.